Definition
Equity beta, also known as leveraged beta, is a measure of the systematic risk of a security or a portfolio in comparison to the overall market. It shows how the investment’s price will move relative to the market, taking into account the debt that the company holds. A beta greater than 1 indicates higher volatility, while less than 1 indicates lower volatility.
Key Takeaways
- Equity Beta, also known as levered beta, is a measure that compares the volatility or systemic risk of a publicly listed company to that of the market. When a company’s equity beta is greater than 1, it means the company is riskier than the market.
- Equity Beta is used in the Capital Asset Pricing Model (CAPM) to calculate the expected return of an investment given its beta and expected market returns. This helps investors make informed decisions about their investments.
- Equity Beta can be influenced by a variety of factors including business cyclical nature, financial leverage, and operating leverage. It is not a constant value and can change over time as the business or market conditions change.
Importance
Equity Beta, also known as levered beta or just beta, is a crucial metric in finance because it represents the volatility or systematic risk of a security or a portfolio in comparison to the wider market.
It is a key contributor to the Capital Asset Pricing Model (CAPM), utilized to calculate the expected return of an investment.
A beta greater than 1 indicates that the investment is more volatile than the market, implying higher risk and potentially higher return, while a beta less than 1 indicates the investment is less volatile.
Hence, Equity Beta helps investors evaluate risk and balance their investment portfolios, making it an important measure in financial analysis and decision-making.
Explanation
Equity Beta, also often referred to as leveraged beta, is a critical tool primarily used by financial analysts, investment professionals, and corporations to measure the volatility or risk of a particular investment, portfolio or a company as compared to the overall market. More specifically, Equity Beta is utilized in measuring the possibility that the investment’s value may change with movements in the correlating market index.
It is widely used in the financial setting to assess risk, calculate the cost of equity, and craft balanced and well-diversified portfolios for investment clients. It plays a pivotal role in the Capital Asset Pricing Model (CAPM), a model that determines a theoretically appropriate expected return of an asset.
Equity Beta essentially helps investors comprehend how sensitive the security is to the overall market risk, and lets investors be cognizant of the possible risks before investing their money. A beta reading of more than one suggests that the investment is more volatile than the market, while a beta reading of less than one suggests that the investment is less volatile.
For instance, if a company has an equity beta of 1.5, it implies that if the market goes up by 10%, the company’s returns are likely to go up by 15%. Conversely, if the market plunges by 10%, the company’s returns are likely to drop by 15%. Thus, it provides valuable information in strategic decision making for investors and financial professionals.
Examples of Equity Beta
Equity beta, also known as leveraged beta or stock beta, reflects the level of correlation between the stock’s price and the market. It is used as an indicator of the market-related risk associated with investing in a particular stock. Here are three real-world examples:Apple Inc: As of 2021, Apple Inc’s equity beta is around
The beta fundamentally shows that Apple’s shares are theoretically 20% more volatile than the market. This could be seen as an added risk to invest in Apple, but it could also mean higher potential returns for investors.Tesla Inc: Tesla generally has a higher beta, roughly standing at 2 as of
This suggests that for every 1% movement in the market, Tesla’s shares may move approximately 2%. Investors viewing Tesla may perceive this as a high risk, yet also as high-return opportunity, should the market continue to perform well.Walmart Inc: On the other side of the spectrum is a company like Walmart with a beta of around
5 as ofWalmart’s share price tends to be much less volatile compared to the overall market. It can be perceived as a safer investment, but the potential returns may be less enticing when compared to higher-beta stocks.
FAQs on Equity Beta
What is Equity Beta?
Equity Beta, also known as leveraged Beta or financial Beta, measures the volatility of a company’s stock relative to the volatility of the overall market. It indicates how much the investment’s price will move relative to the overall market price.
How is Equity Beta calculated?
The Equity Beta of a firm can be calculated using the following formula: Equity Beta=Beta of Assets * [1 + (1 – Tax Rate) * (Debt-to-Equity Ratio)].
What does a high Equity Beta signify?
A high Equity Beta signifies that the stock is theoretically more volatile than the market. It may rise or fall more drastically than the market under the same market conditions. Therefore, a stock with a high Equity Beta is considered more risky.
How can Equity Beta be used in investment decisions?
Investors can look at a company’s Equity Beta to help determine its level of market risk. Companies with a higher Equity Beta may provide higher returns, but they are also generally riskier. Therefore, investors can use Equity Beta to make informed decisions about the level of risk they are willing to take on with their investments.
Is a negative Equity Beta possible?
Yes, it’s possible for a company to have a negative Equity Beta. This means that the company’s stock price goes up when market returns go down, and vice versa. Such companies are considered defensive as their stock prices are less affected by market fluctuations.
Related Entrepreneurship Terms
- Capital Asset Pricing Model (CAPM)
- Systematic Risk
- Unsystematic Risk
- Volatility
- Market Returns
Sources for More Information
- Investopedia – Provides comprehensive explanations of various financial terms including Equity Beta.
- CNBC – Offers news related to finance and economy and also includes definitions of financial terminologies.
- The Balance – This website offers information around various financial topics, personal finance and career advice.
- Morningstar – Provides insightful data and analysis on a wide range of investment options including information about financial terminologies.
